Fred Wilson writes about his “favourite business model.”
Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc, then offer premium priced value added services or an enhanced version of your service to your customer base.
Skype basic in network voice is free, out of network calling is a premium service
Flickr a handful of pictures a month is free, heavy users convert to Pro
This business model has been around for a long time. Shareware always used a model like this and there are many successful software companies that have been built with this model.
It works even better with web native services.